Private Company Council
September 17, 2013
Education Session
PCC Issue No. 13-01A
The views expressed in this presentation are those of the
FASB staff and are intended for discussion purposes only;
it is not intended to reflect the views of the FASB. Official
positions of the FASB are determined only after extensive
due process and deliberations.
1
Valuation Issues Raised in Comment
Letters
In comment letters on proposed Accounting Standards Update, Business
Combination (Topic 805) – Accounting for Identifiable Intangible Assets in
a Business Combination, issued on July 1, 2013, concerns were raised
about whether the proposal would significantly reduce the costs and
complexity of business combinations for private companies. Three areas
of note include:
- Application of the Multi-Period Excess Earnings Method (MPEEM)
would still require the valuation of certain intangibles not separately
recognizable from goodwill
- Rationale for and difficulty and complexity associated with separating
patented technology from unpatented technology
- Complexity and data needs associated with assessing non-cancellable
terms of customer contracts and the valuation of those contracts
2
Overview/Background
3
Valuation Approaches
● The Cost Approach: A valuation technique that reflects the amount that
would be required currently to replace the service capacity of an asset
(often referred to as current replacement cost).
● The Market Approach: A valuation technique that uses prices and other
relevant information generated by market transactions involving identical
or comparable (that is, similar) assets, liabilities, or a group of assets and
liabilities, such as a business.
● The Income Approach: Valuation techniques that convert future
amounts (for example, cash flows or income and expenses) into a single
current (that is, discounted) amount. The fair value measurement is
determined based on the value indicated by current market expectations
about those future amounts.
4
Cost Approach for Intangible Assets
 While occasionally appropriate for intangible assets, the cost
to create many intangibles has little relationship to the value
of the intangible asset.
 The AICPA Practice Aid, “Assets Acquired in a Business
Combination to be Used in Research and Development
Activities,” discusses that relationship for IPR&D:
“By its very nature, the relationship between cost incurred
and value created is tenuous at best for IPR&D projects.
- Certain R&D projects may go on for years at great expense without ever
producing a commercially viable product. In that case, the cost of reproducing
the historical development steps may overstate the value of the technology.
- Conversely, creation of intangible assets with substantial value may be made
for little cost. In this case, the cost of reproducing the historical development
steps would be low compared with the value of the resulting asset/technology.”
5
Cost Approach for Intangible Assets
 As a result, the Cost Approach is typically only used to value
relatively minor intangible assets, such as:
• Assembled workforce (which is not recognized separately
from goodwill, but is often valued because it is necessary
to apply the Multi-Period Excess Earnings Method)
• Internally developed and used software
6
Market Approach for Intangible Assets
 Since the Market Approach, by its nature, requires available
data on transactions involving the same or similar assets, it
is seldom applied to value intangible assets.
- Intangible assets are typically unique (patents, trade
names, and so forth are, by definition, unique)
- There is limited guideline transaction data for intangible
assets
- When intangibles are sold, they are typically sold with
other components of a business enterprise
- If sold individually, transactions are not often subject to
public disclosure
7
Market Approach for Intangible Assets
 As a result, the Market Approach is typically only used to
value a small number of assets for which market data is
sometimes available:
- Domain Names (generally, domain names owned but not
used and unrelated to the core trade name/brand)
- Valuation of Operating Rights
• FCC Licenses
• Telecom Operating Spectrum
8
Income Approach for Intangible Assets
 Because the Cost Approach and the Market Approach are often either not
appropriate or not feasible, estimating the value of intangible assets is most
commonly done through an Income Approach.
 Valuing multiple assets under an income approach typically involves selecting an
appropriate valuation method for each asset based on its characteristics and
importance to the business.
 The methodologies most commonly used are:
- Multi-Period Excess Earnings Method (MPEEM)
- Relief from Royalty Method (RFR)
- “With and Without” Method (WWM)
- Greenfield Method
 Typically, a business’ primary asset is valued under the MPEEM, while any
secondary intangible assets are valued using one of the other methods.
9
Multi-Period Excess Earnings Method
(MPEEM) May Still Require Valuation of
Unrecognized Assets
10
Overview of Issues Raised in Comment Letters
 Respondents raised concerns that the most commonly used valuation
method, the MPEEM, may require the valuation of intangible assets,
even if those assets are no longer separately recognizable from
goodwill.
-
11
MPEEM Overview
 Multi-Period Excess Earnings Method (MPEEM) is an income-based
valuation approach (that is, it estimates value based on expected future
economic earnings attributable to an asset).
 MPEEM is most commonly used to value the primary or most important
asset responsible for the income-generating ability of a business
enterprise or a key segment of a business enterprise.
 Typical intangible assets deemed to be primary income-generating
assets and valued using MPEEM are:
– Customer-related intangible assets
– Enabling (“Key”) Technology (generally sold to third-parties).
12
Prevalence of the MPEEM
 The majority of acquired going concerns are expected to have at least
one asset valued using the MPEEM.
- A small basic firm may have customer-related intangibles (CRI)
requiring valuation using the MPEEM.
- A multi-national corporation could have hundreds of assets requiring
valuation using the MPEEM. Some might be CRI and others might be
technology.
 The AICPA Practice Aid, “Assets Acquired in a Business Combination to
Be Used in Research and Development Activities,” identifies the
MPEEM as the most commonly used valuation method for IPR&D
 Due to the complexities of valuing more than one intangible under the
MPEEM when both assets generate the same revenue stream, auditors
and the Appraisal Foundation have expressed a preference to limit the
use of the method to one asset for any given revenue stream.
13
Primary Assets
 A primary asset is generally considered to be the asset most
responsible for the revenue and profit-making potential for a
business. The primary asset often varied depending on the nature
of a company and its industry. For example, the primary asset for
many consumer products companies is their brands/trade names,
while the primary asset of most service businesses is their customer
relationships.
 In an Appraisal Foundation Discussion Draft, they discuss this
concept as follows:
"In our view, a primary asset of a business is an asset which has significant
importance to the business relative to other assets and is a key business driver from
an economic perspective (e.g., cash flows). Depending upon the nature of the
business, the primary asset(s) may be tangible assets such as real property or
intangible assets such as customers, technology, brands, or another asset."
Source: “Discussion Draft – The Valuation of Customer-Related Assets”, Appraisal Foundation, 2012
14
Key Elements of the MPEEM
 Identification of asset(s) to be valued using MPEEM
 Revenues
- Level
- Remaining economic life
 Development of estimated expenses
 Contributory asset charges
- Identification and valuation of all contributory assets
- Rate of return for each
- Rate of return for subject asset
- Revenue base
15
Appraisal Foundation Discussion of MPEEM
1.3 The MPEEM is a method under the income approach. In applying this form of
analysis, the starting point is generally Prospective Financial Information (“PFI”) for
the entity that owns the subject intangible asset. From this, a stream of revenue and
expenses are identified as those associated with a particular group of assets. This
group of assets includes the subject intangible asset as well as other assets
(contributory assets) that are necessary to support the earnings associated with the
subject intangible asset. The prospective earnings of the single subject intangible
asset are isolated from those of the group of assets by identifying and deducting
portions of the total earnings that are attributable to the contributory assets to estimate
the remaining or “excess earnings” attributable to the subject intangible asset. The
identification of earnings attributable to the contributory assets is accomplished
through the application of CACs in the form of returns “on” and, in some cases, “of”
the contributory assets. These CACs represent an economic charge for the use of the
contributory assets. The “excess” earnings (those that remain after subtraction of the
CACs) are attributable to the subject intangible asset. These excess earnings are
discounted to present value at an appropriate rate of return to estimate the fair value
of the subject intangible asset. Thus, the MPEEM could be described as an attribution
model under the income approach.
Source: “Identification of Contributory Assets and Calculation of Economic Rents: Monograph”, Appraisal Foundation, 2010
16
Appraisal Foundation Discussion of MPEEM
3.1.12 …An important attribute of this method is that it provides the ability to reconcile
to the entity value and demonstrates that the calculation of the CAC does not create
or destroy aggregate asset value. The application of CACs is essentially an attribution
of earnings to the contributory assets.
Source: “Identification of Contributory Assets and Calculation of Economic Rents: Monograph”, Appraisal Foundation, 2010
17
MPEEM as a Sanity Check
 One of the key benefits of the MPEEM is its usefulness as a check on
the reasonableness of a purchase price allocation.
 The MPEEM allows appraisers (and auditors) to understand the
relationship between:
- Revenue and earnings generated by existing assets
- Revenue and earnings attributable to unidentified assets
 For most businesses, it is expected that near-term revenue and profits
would be generated by already-existing assets.
 The example on the next three slides was included in the Appraisal
Foundation’s “Identification of Contributory Assets and Calculation of
Economic Rents: Toolkit”
18
19
20
“Excess Earnings” Attributable to Existing Customer
Relationships vs. Unidentified Intangibles
250
200
150
100
50
0
Year 1
Year 2
Year 3
Year 4
Unidentified Intangibles
Year 5
Year 6
Year 7
Customer Relationship
21
Summary of Comment Letter Issue
 The MPEEM is currently used in nearly every business combination for
at least one intangible asset.
 Even if certain intangibles (for example, unpatented technology and
cancellable customer relationships) are no longer recognized separately
from goodwill, the application of the MPEEM may require their valuation
for purposes of calculating contributory asset charges, just as is
currently done for assembled workforce.
 If the MPEEM is not used, auditors and appraisers would face
challenges gaining comfort with the appraisal, as the MPEEM provides
a significant “check” on the valuation’s reasonableness.
 Based on the above, the proposal may not result in the intended cost
savings to preparers.
22
Rationale for and Difficulty and
Complexity of Separating Patented
Technology from Unpatented
Technology
23
Overview of Issues Raised in Comment Letters
 Respondents raised concerns with several aspects of the proposal to
recognize patented technology as an intangible asset, but not
unpatented technology:
- Patented and unpatented technology can be similar from an
economic perspective, and some respondents questioned why there
would be differences in valuation/recognition.
- As many companies sell products and services that utilize a mix of
patented and unpatented technologies, there may be a significant
cost burden associated with separating out the value of patented
technology.
-
24
Overview of Intellectual Property
 Intellectual property is increasing in significance to the U.S. and global
economies.
 While companies in all industries may have intellectual property, the
U.S. Patent and Trademark Office estimates that 18.8% of people
employed in the U.S. are in industries that are particularly intellectualproperty intensive (Intellectual Property And the U.S. Economy:
Industries in Focus, March 2012).
 Many products and services rely on a portfolio of protected and
unprotected intellectual property (patents, trademarks, copyrights,
know-how, trade secrets, and so forth)
25
When are ideas not patented?
 Many companies are cautious about whether and when to patent their
developed technology. The process of obtaining a patent can cost
upwards of $25,000. As such, a company may wish to assess
commercial viability before undertaking such costs.
 If an idea relates to a method or know-how that is not easily reverseengineered, many companies choose to keep it a “trade secret,” which
may actually increase value, by extending the life of the technology
beyond the life of a patent.
 In some fast-moving industries, obtaining patents may not be important,
because focus is on developing the next generation of technology rather
than using the current technology for a long period.
26
When are ideas not patented?
 Even for technologies that a company plans to patent, it is often prudent
to wait.
 If an idea is patented too early, the patent’s scope may be too narrow to
provide any protection from competitors.
 While it is important to document and establish the date of the
conception of an idea, an inventor has up to one year from the public
disclosure of an invention (by, for example, selling a product) to patent
that idea.
 By filing a provisional patent application, that deadline may be extended
to two years from public disclosure of the invention.
27
Do Patents Have Value?
 While technology is undoubtedly an important part of many companies’
operations, the value of technology generally does not relate specifically
to whether it is patented.
 The majority of parents have no commercial value, generally because
they apply to processes or products that are not being produced by the
patent holder or any potential licensee.
 Ultimately, while a patent may provide useful legal protection, it is not
the driver of value for most technologies.
 Economically, there may be circumstances in which patented
technology would be worth less than an identical unpatented
technology.
28
Complexity of Separating Patented Technology
 Most companies that hold patents do not license them to third parties.
Instead, they hold the patents and use them in their own products
and/or services.
 Those companies often also utilize other intellectual property in
providing their products and services, including unpatented technology
(know-how, trade secrets, and so forth).
 Under current guidance, patented and unpatented technology are often
valued together because they represent a reasonably homogenous
group under FASB Concepts Statement No. 5.
 For companies that utilize both patented and unpatented technologies,
the process of separating the value of patented technology may be
costly.
29
Separating Patented Technology
 In addition to utilizing both unpatented and patented technology, a
product or service may use a number of patents with varying importance
and expiration dates.
 The proposed guidance may require valuation of patents individually
rather than as a group.
30
Summary of Comment Letter Issues
 While patents are capable of being sold or licensed individually, most
companies develop and hold patents for their own use rather than for
sale or licensing purposes.
 A company’s product/service is often a combination of patented
technology and unpatented technology (know-how, trade secrets, and
so forth).
 Economically, a patented technology is often no different from
unpatented technology.
 In many business combinations, separating the value of patented
technology may be more costly than valuing technology as a whole.
31
Complexity and Data Needs for
Assessing Contractual Non-Cancelable
Customer Related Intangibles
32
Overview of Issue Raised in Comment Letters
 Respondents raised concerns that the analysis of contractual, noncancellable customer contracts may be more costly and time-consuming
than current practice.
33
Customer Relationship Valuation - Current
 Under current guidance, customer relationships are often valued as a
group, because many businesses’ customers represent a reasonably
homogenous group under FASB Concepts Statement No. 5
 For many businesses, customers are sufficiently similar such that the
valuation requires only a single valuation model with two primary inputs:
- Amount of revenue from existing customers in “Year 1”
- Attrition rate
 Attrition is an area that has received significant scrutiny from auditors
and the PCAOB, because many appraisers have historically used
management estimates/assertions.
 Best practice requires management/appraisers to gather historical
customer information (typically revenue by customer for two to five
years) to calculate an attrition rate.
34
Example of Current Practice
35
Customer Relationship Valuation - Proposed
 Management and appraisers (and potentially legal counsel) will need to
review the subject company’s contracts to determine whether they meet the
definition of non-cancellable. If all of a company’s contracts have uniform
terms, this process may be as simple as reviewing a single contract, but it
could involve reviewing each contract in some circumstances.
 If the subject company is determined to have non-cancellable contracts, the
non-cancellable term of each contract will need to be determined.
 To the extent a company’s contracts have varying economics and start/end
dates, they may need to be valued individually or in groups with the same
terms.
 While an attrition analysis would no longer need to be prepared, the
additional time and cost associated with assessing non-cancellable
contracts may outweigh the time and cost associated with gathering and
analyzing a few years of historical revenue by customer.
36
Summary of Comment Letter Issue
 For acquisitions of certain targets, the proposed standard would
undoubtedly reduce costs:
- For companies with uniform contract terms and start/end dates, there
would be no need to perform an attrition analysis.
- If a target has no non-cancellable contracts, customer relationships
would not be valued.
 For acquisitions involving targets with non-cancellable contracts with
varying start and end dates, the proposed standard may increase costs,
requiring management and valuation specialists to analyze individual
contracts rather than valuing customer-related intangibles as a group.
37
Questions?
38